An Economic Framework of Demand Response in Restructured Electricity Markets

This paper provides a unified economic framework for assessing the effectiveness of priceresponsive demand in promoting efficient electricity markets. The framework recognizes the interactions between a competitive wholesale market and regulated uniform retail rates within a hybrid market structure. The framework features the basic principles of marginal cost pricing in the wholesale market and average cost pricing in the retail market while applying the advanced theory of priority service to shortage/scarcity pricing. The analysis addresses the institutional and technical barriers that create an asymmetric information structure between consumers and producers inhibiting efficient price responsive demand in electricity markets. The analysis indicates that while demand response incentives could potentially alleviate the inefficiencies before these barriers are removed, the use of Customer Baseline is susceptible to gaming problems, and it could also create an excessive incentive inadvertently causing inefficient price formation. If not corrected, this could result in inefficiencies that would outweigh the benefits of demand reduction during the peak period and increase the average cost to the final consumers.